Q&A: Stanford's Taylor argues for higher interest rates

At the World Bank 2015 Spring Meetings, Economist John Taylor, author of the "Taylor rule," talks about how monetary policy rules shape economic strategy.
USA TODAY

Stanford University economist John Taylor is a leading critic of Federal Reserve policies that have kept the Fed's benchmark short-term interest rate near zero six years after the Great Recession ended. The "Taylor rule" he proposed in the early 1990s is a formula that stipulates what the Fed's benchmark rate should be based on inflation and the level of economic growth. It's now a model for a House bill that would force the Fed to base its interest rate decisions on a rule.

USA TODAY economics reporter Paul Davidson spoke with Taylor, who is attending the World Bank-International Monetary Fund spring meetings in Washington this week.

A. The rule is like a strategy. Like anything in life or government, it's better when you know what the strategy is. Otherwise it's all tactics. We'll wake up tomorrow and decide what we'll do. And next week we'll decide to do something else. What we are finding out now is when (Fed officials) have deviated from these rules or strategies we can actually see that things haven't turned out so well.

Q. What about the argument that a fixed rule doesn't account for the complex, ever-changing dynamics of the economy?

A. A lot of the reaction to this is that the Fed shouldn't be chained to a mechanical rule. But it's never been a mechanical rule, and it's never been chaining the Fed. In fact, the legislation that's being discussed has the Fed determine its rule. And they don't have to always stick to it. In that case, they just have to give the reason.

Q. Have previous Fed policymakers followed your rule in their interest rate decisions?

A.(Not) in the late '60s and '70s. It was very discretionary, and so it was a mess. And then in the '80s and '90s with (former Fed chairmen Paul Volcker and Alan Greenspan), their interest setting was actually close to a rule. Then things changed and it went back again. If they had adhered to (a rule) in 2003, '04, and '05 we wouldn't have had the (housing) boom and bust and therefore the Great Recession we had.

Q. What would the Fed's benchmark rate be today if it were following the Taylor Rule?

A. Between 1.25 and 2%.

Q. So I assume that's where you think it should be right now?

A.Yes, and I would always emphasize you have to move there gradually. I mean they're not there now. So going from .25% to 1.25% overnight would not be a good idea.

Q. Many people think the Fed's policies have worked pretty well and give the Fed credit for getting us out of the financial crisis and growing the economy and job market again.

A. During the panic in the fall of 2008 I think that they did a very good job. They helped stop the panic. Then they started the (bond purchases to our long-term rates). I have questions of the impact of that and the low interest rates.

Q. Another criticism is that times are different now. We're coming out of a recession, and there are many lingering obstacles to growth. Credit is still tight and the unemployment rate doesn't reflect all the discouraged workers who have stopped looking for jobs.

A. The (rule) is designed to respond to this stuff (because it accounts for) when GDP is below its normal level. Why should it respond more? Right now, the panic is six, seven years ago. The financial sector seems to be doing just fine. The economy could be growing faster, but it's not like there's particular stresses. There's no magic wand that says when times are normal.

Q. Some economists cite long-term changes in the economy as the reason for slow growth and the need to keep interest rates lower for longer. For example, the global population is aging, and there's been less productivity and innovation.

A. Whether you agree with that or not, it's not really something that monetary policy should be responding to.

Q. Since we're at the IMF conference, you also think foreign interest rates are too low and are failing to follow a rule, correct? And that after low U.S. rates weakened the dollar and bolstered U.S. exports, other countries had to do the same for competitive reasons.

A. Yes. One (low-rate policy) begets (another). Our low rates have affected the rates of emerging markets, as well as Japan and Europe.